Understanding the New Price of Oil

In the spring of 2011, when Libyan oil production -- over 1 million barrels a day (mpd) -- was suddenly taken offline, the world received its first real-time test of the global pricing system for oil since the crash lows of 2009.

Oil prices, already at the $85 level for WTIC, bolted above $100, and eventually hit a high near $115 over the following two months.

More importantly, however, is that -- save for a brief eight week period in the autumn -- oil prices have stubbornly remained over the $85 pre-Libya level ever since. Even as the debt crisis in Europe has flared.

As usual, the mainstream view on the world’s ability to make up for the loss has been wrong. How could the removal of “only” 1.3% of total global production affect the oil price in any prolonged way? was the universal view of “experts.”

Answering that question requires that we modernize, effectively, our understanding of how oil's numerous price discovery mechanisms now operate. The past decade has seen a number of enormous shifts, not only in supply and demand, but in market perceptions about spare capacity. All these were very much at play last year.

And, they are at play right now as oil prices rise once again as the global economy tries to strengthen.

The Subordination of Cushing

Through the dominant force of its own demand, the US economy largely controlled the oil price for many decades. For years, it was common practice therefore to gauge world demand through the weekly updates to oil storage at Cushing, Oklahoma as well as total oil storage in the United States. If the US was demanding more oil from the global market, and thus either not adding to oil inventories or drawing them down, then a signal was given, pointing to future oil price strength.

But this dynamic began to break down coming into 2005-2007. That was the period when US oil demand -- because of rising prices -- began its current decline. Now that US oil demand is down over 12% from its mid-decade peak, the fluctuation of oil inventories in the US no longer drives prices.

The chart below shows that US inventories have been on an upward trend since 2005, and are now near decadal highs above 300 million barrels even though oil prices are back above $100:

What we're now seeing is that US inventories and US demand are now subordinate to numerous other factors, ranging from emerging market demand, to market perception of spare capacity.

Lessons of Libya

A useful fact learned during last year's Libyan civil war is that Saudi Arabia does not necessarily possess the 2-3 mbd of spare capacity which most have assumed for years. Moreover, Saudi Arabia ceded the position of top world oil producer to Russia over 5 years ago in 2006. Indeed, Saudi Arabia made no production response to the loss of Libyan oil last spring. Producing near 9 mbd, it was only by June that Saudi production was lifted by 600 thousand barrels a day (kbd). That is a hefty production increase to be sure, but it raised questions as to how quickly spare capacity in the world can be brought online.

By the time Saudi Arabia had lifted production, the OECD countries led by the IEA in Paris had already decided to release oil from official inventories. But this, too, did little to calm oil prices -- and as I pointed out last June, only created further problems. In The Dark Side of the OECD Oil Inventory Release, I explained that, by lowering OECD inventories, the market would correctly deduce that safety buffers had been reduced further. Combined with the Saudi increase in production, this only reduced spare capacity further.

The result was even stronger prices as WTIC ran back to $100 (until all global markets floundered on a flare-up in the EU financial crisis). Indeed, it is no longer US inventories of crude oil but the fluctuations in the emergency cushion of all inventories in the OECD (of which the US is part) that is now the more important factor in oil prices:

The loss of Libyan production caused a dramatic drawdown of OECD total oil stocks, which were already in a downward trend starting the previous summer in 2010. OECD inventories fell on both an absolute basis and on a comparative basis to the trailing 5-year average, as the above chart shows. Taking these inventories from a high of 2800 mbd to 2600 mbd onlysix months later, combined with unrest across the entire Middle East, was more than enough support to boost WTIC oil prices from $85 to above $100 last spring. Additionally, as we can see in the chart, the decline in OECD oil inventories was maintained into the end of 2011.

These are important conditions to consider when trying to understand how oil prices now, in early 2012, are once again on the rise.

The Decline of Spare Production Capacity

The latest global production data shows that Saudi Arabia was producing 9.4 mbd on average during 2011, an increase of 500 kbd over 2010. To accomplish this, The Saudis had to increase production from 9 mbd in 1H 2011 to 9.8 mbd during 2H of 2011. But paradoxically, this production increase has only made the global oil market even tighter, as spare capacity shrinks further.

Let's recall that nearly 60% of global oil supply comes from outside of OPEC from countries like the US, Canada, Brazil, Mexico, China, Australia, and the big producer, Russia. There is no spare capacity in this non-OPEC grouping, and there hasn’t been for years. Sure, there is oil to be developed in non-OPEC countries; but that is not production capacity (meaning it is not supply that can be brought online quickly).

Moreover, Russia, the country that single-handedly saved non-OPEC production from going into steep decline, massively increased its contribution to world supply in 2002. But in the past two years, it has seen its production growth taper off and flatten, to just shy of 10 mbd.

That leaves the oil market, tasked with the job of pricing, to figure out the ongoing mystery that is the "true" spare production capacity in OPEC. That it took 4-5 months for Saudi Arabia to increase production is a concern. Such delays should seriously give pause to those analysts who’ve regurgitated the belief over years that Saudi has 2-3 mbd that can be brought on quickly.

Although EIA Washington currently judges OPEC spare capacity to be higher than during the lows of 2003-2008, its historic figures show that spare capacity has been declining since a 2009 high.

Moreover, the failure of non-OPEC production to increase within last decade counts as a true surprise to the global oil market. The faith in non-OPEC supply over the last decade helped to keep prices subdued, until that faith was shattered by 2007's wild spike.

The problem now is that the oil market has been re-educated. Faith in the non-OPEC countries' ability to increase supply is no more. Meanwhile, the great deceleration in Russian oil supply growth has spooked the market. Combined, a market with 74 mbd of production and a theoretical spare capacity of 3 mbd simply creates too much uncertainty.

And consider this: the amount of total spare capacity is now equal to the 3 mbpd of demand that’s been taken offline in Europe, Japan, and the United States over the past 7 years, as oil prices have risen from $40 to the $100 level. Thus the oil market has quite correctly rationed supply, at higher prices. If prices were to fall to $50 or $60, the world’s lost demand could be rebuilt rather quickly.

Killing discretionary demand is now the proper function of the oil market in an age of flat supply growth.

Quantitative Easing and Granger Causality

We should also remember that the global economy would be mired in a textbook deflationary depression were it not for the continual and gargantuan US$ trillions that have been provided by central banks since 2008.

Early 2009 saw oil prices slip briefly below $40. But, of course, that's the price level appropriate to a world during an industrial crash -- with reduced shipping, halted economies, and dislocated consumer demand. The world can have those prices again, if it chooses. But it must also be willing to accept a global recession to achieve such low oil prices.

Thus, there is a misconception that currency debasement is the main driver of oil prices. However, given the new supply realities, that simply isn't true any longer.

The chart below is helpful in explaining why. There is no question that coming out of 2000, the decline of the US Dollar as expressed by the USD Index was a true component of the rising oil price. During that period, as the USD was falling, global oil supply was still increasing. The descent of the US Dollar was unquestionably part of the repricing process, as the USD Index fell from a high of 120.00 in 2002 to 80.00 in 2005:

But see how the most ferocious part of oil’s price advance started to unfold after 2005, when, as the USD continued falling, the global supply of oil stopped growing.

If we think of this comprehensively, we have to conclude that the debasement of currencies is no longer the primary factor in the price of oil on a valuation basis. Rather, it is that quantitative easing prevents a deflationary industrial collapse, thus keeping the global economy alive and able to consume more energy.

We can therefore say that in our post-credit bubble collapse era, and with global oil supply now flat, that quantitative easing causes higher oil prices (through Granger causality). It keeps economies from collapsing (for now) and thus brings demand up against very tight supply. As we can see from the chart above, the USD Index has for 3 years now been bouncing off the bottom it first reached in 2008. In a way, this is helpful because it brings to light the new dominant factor in global oil prices: supply.

Supply is Now Primary

Supply and the recognition of supply are now the dominant factor in the oil price -- a point so obvious, it hardly seems worth making. However, the developed world is still largely operating on the classical economic view that higher prices will make new oil resources available.

That is true. But, it’s just not true in the way most anticipate.

While higher prices have brought on new supply, these resources have been slow to develop, are more difficult to extract, and generally flow at lower rates of production. As the older oil fields of the world decline, the price of oil must reflect the economics of this new tranche of oil resources. There are no vast new supplies of oil that will come online in 2013, 2014, and 2015 at the scale to negate existing global declines.

During the entire time that global oil supply has been held at a ceiling of 74 mbd, since 2005, a lot of new production in the Americas and Africa especially has come online. But it has not been enough to increase total world supply. And the price of oil has finally started to price in that new reality.

Here Comes Volatility in Oil Prices

The pricing dynamic discussed above is accentuated by the crisis cycle: the repetitive oscillation between acute and chronic phases of the ongoing debt crisis, mitigated by central bank reflationary policies.

Generally, it appears that the oil price is making its move too early in the year -- which will likely serve as a sucker punch to the fragile world economy -- thus making spectacularly high prices before year end less likely, and a sharp market correction and return to economic recession more so.

Investors will be wise to take prudent precautions before this nasty wake-up call arrives.

Same goes for their crude oil imports, which hit a record high of 23.41 million metric tons this past January, up 7.4 percent year-over-year.10 The so-called experts have a habit of downplaying these numbers, but it seems pretty clear to us: China isn’t waiting around for next QE program. They are accelerating their move away from paper currencies and into hard assets.~Sprott

[7 barrels to a MT so 23,410,000 * 7 =163,870,000 barrels.]

China is shunning its Bernanke food---an unintended consequence of QE, a side effect, quite possibly---worse---than a devalued dollar is demand on limited resources.

Same goes for their crude oil imports, which hit a record high of 23.41 million metric tons this past January, up 7.4 percent year-over-year.10 The so-called experts have a habit of downplaying these numbers, but it seems pretty clear to us: China isn’t waiting around for next QE program. They are accelerating their move away from paper currencies and into hard assets.~Sprott

[7 barrels to a MT so 23,410,000 * 7 =163,870,000 barrels.]

China is shunning its Bernanke food---an unintended consequence of QE, a side effect, quite possibly---worse---than a devalued dollar is demand on limited resources.

Globalization was a genius idea.

The automobile was never a good idea on such a mass, global scale. It's making us all road-kill.

I don't think China has a quarter of the registered vehicles that we have. I'll check but I'm pretty certain. Your point is well taken though. I think a large part of China's Oil imports now are to fill their SPR. However, no question they have locked in alot of future Oil. What I don't quite understand is why they are paying so much for resourses now. The economies of the world are ready for a serious downside, and their dollars could be stretched alot further than now that's for sure.

But weight, there's more. Not assuming there is such a thing as "oil constraints" check this out... This was done in 2006 by our government's DOE national lab. They were conservative by todays reality.

As for the additional stress on oil just from Asian demand, there are many numbers, BPs (Big Petroleums spill) are pretty good, so far as I'm concerned.

Davos, regardless of what the actual numbers are for both countries I think we can both agree that these motorized transports are a relic as we speak because we won't have enough oil to feed their engines in 20 years at the rate of current consumption, depletion, and hoarding by producer states for internal use. India with their 1.5 Billion are ready to get into the fray themselves. This is going to be really ugly, really fast.

WTF are we doing anyways, I just cannot understand why we haven't moved on anything. The Keystone pipeline should have been a no brainer. yet...?

BOB

PS: Davos, I normally never contradict a poster but we haven't really been introduced. I like your work ethic, and so I thought I would say hello.

Davos, regardless of what the actual numbers are for both countries I think we can both agree that these motorized transports are a relic as we speak because we won't have enough oil to feed their engines in 20 years at the rate of current consumption, depletion, and hoarding by producer states for internal use. India with their 1.5 Billion are ready to get into the fray themselves. This is going to be really ugly, really fast.

WTF are we doing anyways, I just cannot understand why we haven't moved on anything. The Keystone pipeline should have been a no brainer. yet...?

BOB

PS: Davos, I normally never contradict a poster but we haven't really been introduced. I like your work ethic, and so I thought I would say hello.

Bob, I often make misstakes, so glad you pushed back on this. I think what tossed you was I used 5.5 million CARS in 1990 and then switched to VEHICLES in 2011. I'm right on the numbers, but I've scr#wed other #'s up before so it doesn't hurt for someone to question anything.

Always a good read Gregor. One thing I have been curious about is by what mechanism oil is actually priced. There was a book written recently, "The Asylum", about New York traders who drove the oil price up in the 2008 spike all by themselves, holding the world hostage unti the whole scheme fell apart. I haven't had time to get very far through the book but it seems that since every other market is now completely rigged with Fed juice, is it not reasonable to assume that oil price is as well, since that is the one commodity whose price (except maybe gold) the Fed is most interested in controlling in order to be able to continue its money printing without causing inflationary spikes? Where is the price of oil actually set?

....point wasn't missed at all. 70% of fuel use is used for the movement of people by the internal combustion engine. If China and the US had the same numbers then we would really be screwed right now from a supply/demand standpoint. That's what I was thinking. China's information czar (?) says they will have a vehicle fleet our size by 2020, and so I go with that. Like our information czar's (BLS for example) I take everything with a grain of salt.

China, and their Centrally run government gets chitzit done. Then again, I don't know why they have the infrastructure they have when clearly ours is obsolete due to the fact that we need electric rail, and mass transit more than the internal combustion engine. We know how to do rail, and must build it right alongside our new electrical smart grid. Lots of jobs there on something we should have started years ago. Could have paid for it with all the big bucks used for blowing chitzit up over there in the really big sand boxes, and the after hospital care of our babies getting blown up by pipes in those ridiculous wars.

Last I looked we can't afford asphalt so are reverting back to gravel roads in many towns USA.

This discussion could go on for days, and frankly what would the point be. We are 20 years too late from starting to correct an enormous problem.

...to spend more time on this than was necessary.Too funny...You win, yippee. Go Tigers...Go Wings

BOB

That last post had nothing to do with your comment Bob. I saw Krasting's fine post on 0Hedge and cleaned up his graphic and posted it on my blog and then on this blog. Tomorrow I might post it on Quinn's blog as well.

When I look at my search engine trafiic logs it is apparent that a lot of people want to know why oil is going up.

What is interesting about Krasting's graphic is that he did the math that I and Sprott did but Bruce put it into simple terms, 40% increase in imports is HUGE. Small wonder why prices are going up.

Last month, the average fuel economy of a new car purchased in the U.S. was 23.7 miles per gallon, compared to 23.5 miles per gallon the previous month, according to the University of Michigan Transportation Research Institute (UMTRI).

That may not seem like much, but over the last four years, UMTRI reports that fuel economy has risen 16 percent.

The most obvious driver of the trend is economic, and such concerns are unlikely to go away. The average gallon of regular gas sold for $3.75 on March 1 - 20 cents more than at the start of the year, according to the American Automobile Association (AAA). Fears of $5-per-gallon gas no doubt fuel the interest in more fuel-efficient vehicles.

So it’s no surprise that sales of hybrids as well as smaller, fuel-efficient cars are up. In January and February, Toyota’s Prius sales were up 33 percent (compared to the same period last year), while GM’s Chevrolet Cruze jumped 10 percent.

In 2010, American light-duty cars had an average fuel economy of 22.5 miles per gallon, 17 percent higher than the average fuel economy in 2004. Automakers are gradually increasing fuel efficiency to meet the 2025 fuel efficiency goals set out by the Obama Administration last year. The Corporate Average Fuel Economy (CAFE) standards will require fuel efficiency of 54.5 miles per gallon.

That may not seem like much, but over the last four years, UMTRI reports that fuel economy has risen 16 percent.

The most obvious driver of the trend is economic, and such concerns are unlikely to go away. The average gallon of regular gas sold for $3.75 on March 1 - 20 cents more than at the start of the year, according to the American Automobile Association (AAA). Fears of $5-per-gallon gas no doubt fuel the interest in more fuel-efficient vehicles.

So it’s no surprise that sales of hybrids as well as smaller, fuel-efficient cars are up. In January and February, Toyota’s Prius sales were up 33 percent (compared to the same period last year), while GM’s Chevrolet Cruze jumped 10 percent.

In 2010, American light-duty cars had an average fuel economy of 22.5 miles per gallon, 17 percent higher than the average fuel economy in 2004. Automakers are gradually increasing fuel efficiency to meet the 2025 fuel efficiency goals set out by the Obama Administration last year. The Corporate Average Fuel Economy (CAFE) standards will require fuel efficiency of 54.5 miles per gallon.

I think were all in a gamble of how much any currencey is "worth" at this point. Only time will be the truth sayer, yet i feel China has the upper hand. If I had the money china has, due to there enourmous production, I would use ALL of that fiat bullshit to buy up ALL of the resources i could at the time and not worry about stretching that dollar cause that, in a sense, is what there doing. I think the race is on. And i think were loosing......

James Rickards book "Currency Wars" really takes a good perspective on this. Its a must read.

Here in northern California gasoline is now retailing for $4.20 a gallon. Prices haven't been this high since mid-2008. Forecasts for $5 per gallon gas in the US this summer are now commonplace. What's driving prices up?

Most analysts focus mostly on two factors: worries about Iran and increased demand from a perceived global economic recovery. However, as we will see, there are also often-overlooked systemic factors in the oil industry that almost guarantee us less-affordable oil.

Iranian Poker

Iran wants nuclear power and (probably) the capacity to build a nuclear weapon; the latter is unacceptable to Israel and the US. But there is more to the standoff than this. Iran is a strategic oil and gas exporting country that, for the past 30 years, has escaped integration into the US system of client states; it also occasionally provides assistance to Israel's enemies. Following the disastrous US invasions and occupations of Iraq and Afghanistan, Iran has emerged as the principal power in the region, capable of further destabilizing either of its war-torn neighbors. And Tehran has led a move to ditch the US dollar as the standard currency of exchange in the global oil market.

Western sanctions include oil export embargoes that will gradually tighten over the coming months. Tehran has turned the threat around by proactively cutting off supplies to France and the UK. If the situation spins out of control in any of several possible directions, oil prices could shoot to $200 a barrel. So worry alone is keeping prices up.

Of course, the downside of open hostilities could include much more than unbearable oil prices. Nearly the entire Middle East could be thrown into chaos for the foreseeable future. It's even conceivable that Russia and/or China could be drawn into the conflict in some way.

Hungry Chinese Hordes in Buicks

Meanwhile oil prices are also tied to shifting assessments of the state of the global economy. On days when the financial news is good, oil prices nudge up; on days when the luster on the latest Greek bailout package fades, oil prices tumble. The ongoing Greek debt crisis promises to plunge the EU into recession this year; on the other hand, the Dow Jones average is flirting with 13000.

If the world economy consisted only of the US and the EU, oil prices would probably be trending substantially lower than they are. But China increasingly commands attention. There, oil consumption is still soaring (it grew 6 percent in 2010 and again in 2011), and the Chinese are better able to withstand high prices because they wring more economic utility from every precious drop. The situation must be puzzling for many Americans. With gasoline consumption in the United States at a five-year low and domestic oil production at a six-year high, it seems incomprehensible that prices would be staging a rally. Americans have to get used to the idea that the US is no longer at the center of the universe.

Then there are oil supply disruptions in South Sudan, Syria, and Yemen. And of course those pesky oil-futures speculators, who pile on to magnify trends on both the upside and the downside.

Yet these are all short-term factors; there are also slower-acting forces pushing up petroleum prices. And it is these that we really should be paying attention to, because they will be with us for years to come and are generally very poorly understood.

The Peak of Peak-Oil Denial

Costs of production are rising inexorably—and fairly rapidly—as a result of replacement of conventional crude with oil produced from horizontal drilling and hydro-fracturing, ultra deepwater drilling, and tar sands. Only a decade ago, a world oil price of $20 per barrel evidently provided plenty of incentive for the industry to develop new supply sources, as total global production continued to increase year after year. Today, most new projects look uneconomic if oil prices are anything shy of $85. Ironically, pundits often depict this shift as a miraculous new development that promises oil aplenty till kingdom come.

During the past few months, op-eds and talking heads have announced the death of "the peak oil theory" even as actual world crude production rates remain stagnant and oil prices soar. The fallacy in this thinking arises from a confusion of reserves with production rates. With oil prices so high, staggering quantities of low-grade hydrocarbons become theoretically profitable to produce. It is assumed, therefore, that the scarcity problem has been solved. If we extract enough of these low-grade resources, that will bring oil prices down! But of course, if the oil price goes down then these unconventional sources become uneconomic once again and effectively cease to be countable as reserves.

The absurdity of the "new golden age of oil" line of thinking will take a while to reveal itself; how it will do so is fairly easy to divine from trends in the "fracking" shale gas industry, where temporary abundance (due to high rates of drilling a few years ago when gas prices were high) has driven gas prices back down to the point where producers are losing money, cutting drilling rates, and selling off leases. All that's left to this sad story is the coming denouement, wherein shale gas producers go bankrupt, production rates fall, and the nation finds itself back in the midst of a natural gas supply crisis that pundits claimed had been deferred for a century.

The oil problem can be summed up simply: Fossil fuel supply boosters know how to add, but they've forgotten how to subtract. Seeing new production coming on line from North Dakota, for example, they extrapolate this growth trend far into the future and forecast oil independence for the nation. But most US oilfields are seeing declining rates of production, and individual wells in North Dakota have especially rapid decline rates (up to 90 percent in the first year). Do the subtraction properly, and it's plain that net supplies will continue growing only if drilling rates climb exponentially. That, again, spells higher production costs and higher oil prices. If the economy cannot support higher prices, and hence high drilling rates, then net total rates of production will drop. The one future that is impossible to achieve in any realistic scenario—low prices and high production rates—is precisely what is being promised by politicians and oil industry PR hacks.

Oil and Politics: Together Again

What will happen later this year if gas prices do break the $5 per gallon psychological barrier?

First, the problem is likely to directly impact the US far worse than most other nations. Countries that tax fuel at high rates (including most European nations) have in effect already adapted to higher prices and will therefore be somewhat cushioned from the impact. Meanwhile countries that export oil will actually benefit from expensive crude.

Some analysts have suggested that price run-ups of the past few years have forced the US to adapt, and that America is now more resilient to oil price shocks than was formerly the case. Our new cars are more fuel efficient, and most industries (including the airlines) have by now factored higher oil prices into their business models. There is some truth to this, but the adaptation is only partial at best. When gas hits $5 a gallon, consumers will need to cut back somewhere. They're already in debt up to their eyeballs and facing stagnant or declining household incomes. Something has to give.

Let's not forget (though we wish we could): it's election season! Republicans are already hammering Obama over the prospect of $5 gas and promising that, if elected, they will drive prices down to half that level. Meanwhile, with the exception of Ron Paul, they're demanding harsher dealings with Iran, and are thus exacerbating one of the primary factors driving prices up. Altogether, it's a neat trick.

Obama will be doing everything he can to keep gasoline prices in check. But what are his options? He could open up the sale of drilling rights on more federal lands—yet while that might make the fossil fuel industry happy, it will have no immediate impact on oil markets.

The one thing he could do that would have some short-term effect is to sell oil from the Strategic Petroleum Reserve (SPR) on the open market. The day of the announcement, oil prices would plummet. They might remain depressed $10 or more for a few weeks, but the impact would only be temporary. Meanwhile Obama's Republican rivals would decry the use of the SPR for political purposes. Opening the SPR would in any case offer no solution to the deeper problems making fuel less affordable. And an emptying of the SPR prior to a potential showdown with Iran over the Strait of Hormuz would indeed be foolish.

In fact, the only thing likely to reduce prices substantially and for a long period of time is serious, prolonged global economic contraction. But this is unlikely to be a plank in any candidate's platform.

Lots of smart people will be striving to manage these worsening problems. Obama will try to keep a lid on the Israel-Iran dispute until after the election. He'll aim to keep gas prices down while appearing to give every possible perk to the oil and gas industry. He'll also try to keep impacts to the economy minimal—or at least delay the release of statistics that reveal just how bad the situation really is.

At the same time, though, his political enemies will be highlighting economic damage and trying to exacerbate the geopolitical crisis.

Keeping this simmering pot from boiling over may just be more than mere mortals can do.